Interest-only mortgages: need to know

Almost half (48%) of UKhomeowners with interest-only mortgages won't be able to clear their debt once their loan matures, according to research carried out by the Financial Conduct Authority (FCA).

Its figures show that of the 2.6m interest-only mortgages due to finish between now and 2041, 1.3m homeowners will have no way of being able to pay off the capital and will face an average shortfall of more than £71,000.

If you have an interest-only mortgage and could be affected, here's what you need to know.

1. What exactly is an interest-only mortgage?

Interest-only mortgages became popular during the 1990s and the early noughties because they made home loans more affordable to buyers who otherwise would have been overstretched financially.

With an interest-only mortgage you only pay back the interest charged each month, leaving the amount borrowed (the capital) untouched. However, once your mortgage reaches the end of its term, you'll need to pay off the capital debt.

To ensure you'll be able to do this, funds should be saved or invested separately into an investment vehicle, such as an ISA or endowment.

By comparison, a repayment mortgage requires you to pay off both the interest and the capital – making monthly mortgage repayments more expensive.

2. What is the problem with interest-only mortgages?

One of the problems with interest-only mortgages is that investments have largely underperformed, and, as a result, many people have been left with a shortfall at the end of the mortgage term.

The FCA research also found that 10% of interest-only mortgage borrowers haven't saved into an investment vehicle at all and so have no way of paying back their capital.

When house prices were rapidly rising many people relied on this equity to pay off the home loan at the end of the term but – as we have seen since the credit crunch – this is not guaranteed.

3. Are interest-only mortgages still available?

Concerns about interest-only mortgages have led to a clampdown from the nation's lenders. Some, such as Lloyds TSB and Santander, have tightened up their criteria for granting interest-only mortgages, while others, including NatWest, Nationwide, HSBC, Coventry Building Society and The Co-operative no longer offer them at all.

4. What should I do if I have an interest-only mortgage?

If you have an interest-only mortgage and you are concerned that you won't be able to clear your debt when the loan matures, speak to your lender to see what your options are.

Switch to a repayment mortgage

Your lender might, for example, suggest you switch to a repayment mortgage. But to do this you may need to brace yourself for higher monthly repayments. For example, the difference in cost between a £150,000 repayment and a £150,000 interest-only mortgage at 5% over 25 years is £250 a month.

Overpay

If you can't affordthis, try to overpay on your mortgage each month instead. Many lenders will allow you to overpay by 10% each year without incurring a penalty.

Remortgage

It's worth checking whether you are currently on your lender's Standard Variable Rate (SVR), which is the rate your mortgage reverts to at the end of, say, a fixed rate or tracker deal. The average SVR is currently 4.24%, according to MoneySupermarket figures, but some SVRs are much higher.

If you are paying SVR, find out whether you can switch lenders and take advantage of a better mortgage rate, particularly if you have built up significant equity in your home. It's unlikely you'll be able to switch to another interest-only deal, but thanks to record-low mortgage rates, you may be able to move to a repayment deal and keep your monthly mortgage repayments at a similar level.

Sell up

A final option – and one that's likely to be more of a last resort – is to sell your home and either downsize, to give you a smaller mortgage, or rent for a while.

But the key is not to bury your head in the sand. Take action now by talking to your lender and also consider seeking advice from an independent mortgage advisor, such as London & Country, who can be contacted on 0844 209 8725 and won't charge a fee.

Disclaimer: Any content in our family money section is intended as general information only. For specific advice about your personal financial situation, get advice from qualified, independent, regulated professionals.